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University of Manchester and Centre for Economic Policy Research.
International Monetary Fund and Centre for Economic Policy Research. The Research reported in this paper was begun while Michael Artis was a Visiting Scholar in the Research Department of the Fund.
It should be noted, however, that in the same paper, Wren-Lewis critically analyzes many of the assumptions of the DEER approach and explicitly mentions the hysteresis effects which are the topic of this paper (page 83).
Note that we specifically do not address hysteresis effects that might arise in other ways, e.g., through shifts in the NAIRU or on account of the presence of set-up costs in international trade.
This paper is not concerned with estimating desired equilibrium exchange rates, but rather with illustrating how such estimates must be adjusted in order to allow for movements in net asset stocks arising from misalignment. Any actual numbers assigned to DEERS in the paper are for purely illustrative purposes, and should therefore be treated as strictly hypothetical.
In some computations, a desired value of the fiscal deficit is also involved, but the assumption here is that there is no additional effect of fiscal policy to be allowed for on top of its effect on u--i.e., that changes in fiscal policy will not shift the schedules. To a good first approximation, this seems a reasonable assumption.
It might be objected that the short-run elasticities differ from the medium-run elasticities used in constructing the DEER. A further adjustment could be made for any such differences.
The authors have in mind a London bus of traditional type, which allows passengers to leap on at the rear while the bus is moving. A North American alternative would be a San Francisco cable car.
Indeed, given the widespread use of nonfundamental or “chartist” analysis in foreign exchange markets (Taylor and Allen (1992)), and that a high proportion of the chartist techniques which are used are in some way extrapolative (ibid.), one might expect there to be substantial divergences between actual exchange rates and DEERs over time since the use of such extrapolative advice by the market would tend to push the nominal and hence the real exchange rate in the opposite direction to the DEER.
Adjustment to other exchange rates was based on sterling’s weight in the relevant index, using MERM weights.
Note that this is for purely illustrative purposes, with no presumption that any of these real exchange rates actually did coincide with the FEER in 1979.
From the IMF’s International Financial Statistics (IFS) data tape; 1985=100.
In fact, the precise calculations were slightly different because we used percentage differences rather than logarithmic differences, as in equation (1). A spread sheet program was used to perform the calculations.
More exactly, end-1989.
These estimates are used for purely illustrative purposes. They are not endorsed either by the present authors or by the International Monetary Fund.
Real exchange rate data were taken from the IFS data tape.
Again, the actual computations were slightly more complex since actual percentage changes, rather than log-linear approximations, were used.